1 Going Informal: Benefits and Costs Simeon Djankov, Ira Lieberman, Joyita Mukherjee, Tatiana Nenova The Informal Economy Round Table, Sofia, April 18-20, 2002

2 Overview of the issue of formality The entrepreneurs who operate in the informal economy perceive the benefits of doing so to outweigh the costs of going formal. Benefits: Avoid costly and burdensome government regulations Regulations impose both a direct cost in terms of fees or bribes to officials, and indirect costs measured in the entrepreneur’s time spent on fulfilling various requirements and submitting documents. Avoid high and complex taxes: corporate income taxes, social security taxes, VAT or turnover taxes, public service taxes, insurance for employees, etc. Costs: Cannot use government and private sector services: credit, infrastructure services, trade fairs, employee training, etc. Policy changes to induce companies to go formal. Increase the benefits and reduce the costs of formal business activity.

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4 Taxonomy of informal enterprises Subsistence enterprises - mom-and-pop retail trade or small production units. Little promise to “graduate” to the formal sector. Small benefits of formality to government as well. Unofficial or semi-formal business activity - e.g., the company is registered but most employees are not. In ECA, unofficial enterprises can be medium or even large enterprises with sophisticated activities. Considerable potential to “breakthrough” to the formal sector, given proper regulatory and tax incentives. Important potential for high tax collections – government stands to benefit. Dynamic firms whose growth is currently stifled.

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6 Benefits of informality: an example. Business registration The procedures, time, and cost related to obtaining all the necessary permits and licenses, and completing all the required inscriptions, verifications and notifications for the company to be legally in operation (Djankov et al., 2002). The total number of procedures ranges from 2 in Australia to 20 in Belarus and the Dominican Republic and averages for the whole sample. Most procedures are not related to taxation, labor, health and safety, or environment – 6.26 procedures on average are “screening” steps, i.e. unproductive hurdles. Business registration is only one of the various regulations that companies need to comply with, and one of the least problematic for businesses. Acquiring business licenses in specific industries, obtaining permissions to export, registering property as collateral are among the more burdensome processes that an entrepreneur needs to go through.

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8 Further study of informality: The WB “Policy Reform Indicators” 110 countries in total Business registration (completed) Forthcoming Policy Reform Indicators: –Industry-specific business licenses –Commercial dispute resolution –Labor regulations –Access to finance –Taxes and tax administration –Bankruptcy –International trade transactions: Tariff and non-tariff barriers; Going through customs; Quality and technical standards –Domestic competition policy –Definition and enforcement of property rights: Land titles and registration; Minority shareholder rights; Intellectual property rights

9 Who gains from regulatory complexity? The public interest theory: Stricter regulation of producers protects and benefits consumers. The public choice theory: Regulation creates rents for bureaucrats and/or incumbent firms. Stricter regulation is associated with higher corruption and less competition. Evidence: Countries with less limited, less democratic, and more interventionist governments regulate more heavily, even controlling for the level of economic development. Such regulation does not yield visible social benefits. The principal beneficiaries appear to be the politicians and bureaucrats themselves.

10 Costs of remaining informal Limited growth potential – small firms are inconspicuous. No access to business services: assistance with business planning, information about markets and resources, marketing strategies, and financial management. No recourse to the law and justice system. Informal companies cannot enforce contracts and defend their property rights. High cost of bribes so that inspectors can look away. Absence of a safety net - employee insurance and pension systems. Inability to tap formal credit channels, SME assistance programs, etc. Informal sources if finance (personal savings, family or friends, moneylender, pawn shops, remittances from family members abroad) are prohibitively costly, unreliable, untimely and carry significant non-financial risks.

11 Benefits and Costs of Informality for Governments The informal sector reduces the tax base: overstated concern. The formalization of the informal sector reduces the need for poverty combating government programs –subsidized health care, subsidized or free housing, large unemployment benefits, free training, etc. Social costs – people in the informal economy are the first to be hit by worsening economic conditions and also have little to lose from staging protests and demanding support by the government.

12 How to Go Formal? Four relatively painless reforms that would not meet strong political resistance and can be seen as win-win changes for government and business alike: Reducing the number of business licenses, permits, approvals. Streamlining administrative processes. Adopting uniform taxes. Enhancing access to capital.